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Tuesday, February 9, 2016

The Winning Sector and Why

Another day of unsure trading left stocks to move ambivalently today as crude oil fluctuated below $30 and major market indices floated around their opening prices.

After higher supply estimates by the International Energy Agency, traders once again found reasons to sell stocks across the board. West Texas Intermediate contracts which opened at $30.17 fell to just 20 cents off their low at $27.94. Analysts continue to point to a coordinated cut by major oil exporters as the only remedy to low oil prices, a point that is rebutted once more by increased production from OPEC. The International Energy Agency reported that the cartel added about 280,000 extra barrels onto the market with sanctionless Iraq ramping up output in order to join the relentless hunt for more market share. With every day of depressed oil prices, price projections turn bearish and volatility appears to increase. Before this year, only a select few would have guessed contracts could be valued so low.

Because of all the bewilderment over crude oil, suppositions about global growth are being called into question as well. Just as WTI crude has lost just over -25% this year so far, the S&P 500 has dropped -7.91% and the Global Dow has plunged -11.05%. The largest losses have come from European countries saddled with debt and emerging markets in a similar situation. Greece's stock market, the Athens Stock Exchange (ASE), reached a 52-week low today while boasting a -28.59% YTD performance so far. Equities are mostly falling in response to a debt problem that has been alluded to here multiple times. The popular U.S. treasury bond is slowly approaching the bearish signs of an inverted yield curve as 5-year, 10-year, and 30-year U.S. bonds saw their yields drop while 3-month and 2-year notes remained the same. Needless to say, there are large amounts of uncertainty surrounding the future with daily losses adding to the negativity.

What if I told you there are some stocks that appear impervious to these weaknesses? Is there a winner among the losers? And could it be a whole sector? Well, there might be something like that, but its performance isn't explained by strength in the sector, but rather, the cyclical nature of its trading. The Dow Jones Utility Average beat the Total Market average with gains of 0.67%, but that's not even the impressive part. As about 78% of S&P stocks trade below their 200-day moving average, the DJ Utility Index trades around its 52-week high of 629.68. The sector's year-to-date performance is 8.53% in a year that is so heavily defined by weakness and volatility. This deviation can be attributed to a utility stock's tendency to have a lower beta (volatility versus the overall market) than other equities (AEP, a member of the DJU). Because utilities like water and power are supposed as necessary, their financial integrity is less likely to weaken in economic downturns. On top of that, they tend to pay out good dividends with less uncertainty on the price tag. As volatility hits stocks that are more vulnerable to demand and supply shifts, investors rotate their money into stocks like these that can provide more safety than their peers in other sectors.

The utility sector has been in a long slump relative to the major large cap equities in the S&P 500 ever since the crisis in 2008 and 2009 where they had peaked. The long six to seven-year bull market saw the growth of stocks that were more vulnerable and volatile because of easy monetary policy and a cheaper dollar. In 2015, the characteristics of the bull market started to fade away with two tests of the resistance on the ratio chart. This year, the ratio broke through the long-term trend line as money flowed into the less volatile sector. This trend appears sustainable at first because of the uniqueness of such a move, but there may be more behind the move.

Michael Gayed's book Intermarket Analysis and Investing discusses the connection between fundamental, technical, and economic trading. The premise of his book is that a combination of the three kinds of analysis is the best way to produce projections and insights with the most accuracy. Using Dow theory, Gayed shows a connection between the Dow Jones Utility and the trend in interest rates as an insight into the health of the overall market. When interest rates rise as they do in an overheated market, utility stocks lose their capital to other stocks that are on the rise. As interest rates fall, utility stocks benefit from the volatility that usually causes the interest rate cuts. In short, utility stocks typically lead the rest of the market where a peak from the DJU might signal a peak in the DJIA and a trough would signal a near future trough.

The chart above shows the rough trend that can be extrapolated from a comparison of the DJIA and the DJU. So what's next? In the past year or so, two peaks and a trough have been lead by utility stocks and the interest rate trend appears to be convoluted with divergence among the world's major monetary institutions. As for the Federal Reserve's stance, its plan of three quarter point interest rate hikes has stalled with major stock market losses threatening a recession. The sudden and large jump in utility performance shows that investors are predicting interest rates to remain flat for awhile or a reversal of the December hike could be on the cards. The sentiment is exceptionally strong especially given the large period of time that rates were held near zero. There's no doubt, though, the solid dividends from utilities are in high demand in the current trend, so they could be easy buys going through the first two-quarters of 2016. The three instances where utilities lead industrials correctly are significant as well. A gap of about one to two months between the DJU and the DJIA appears to be the norm for the current intermediate-term pattern. Because the move in early 2016 was so strong, the gap between the two possible future peaks could spread out to three to six months. Confirmation is important, so look to see if interest rate hikes are planned and economic health has been restored before projecting a reversal from the DJIA. As for trading utility stocks, long positions in the short term and hold positions in the long and intermediate term.